Global financial crisis, financial contagion and emerging markets

The recent global financial crisis was the first in recent history that was triggered by problems in the financial system of the mature economies. Existing work on financial crisis in emerging market countries, however, almost exclusively focus on the role of financial frictions in the domestic economy (see, for example, Devereux et al., 2006, and Gertler et al., 2007). In contrast, in this paper we propose a two-country Dynamic Stochastic General Equilibrium (DSGE) model to investigate the transmission of a global financial crisis that originates from financial frictions in the rest of the world. We find that the scale of financial spillovers from the global to the domestic economy and trade openness are key determinants of the severity of the financial crisis for the domestic economy. In contrast to the existing literature, we find that the greater a country’s trade integration with the rest of the world, the greater the response of its macroeconomic aggregates to a sudden stop of capital flows. Our results also suggest that the welfare ranking of alternative monetary policy regimes is determined by the degree of financial contagion, the degree of trade openness as well as the scale of foreign currency denominated debt in the domestic economy.